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When Can a Foreign Tax Credit be Claimed?

When Can a Foreign Tax Credit be Claimed?

By Anthony Diosdi

U.S. taxpayers are generally subject to U.S. tax on their worldwide income, but may be provided a tax credit for foreign income taxes paid or accrued. The main purpose of the foreign tax credit is to mitigate the double taxation of foreign source income that might occur if such income is taxed by both the United States and a foreign country. A U.S. taxpayer may receive a “direct” foreign tax credit

Who is the Taxpayer Entitled to the Credit?

Under Internal Revenue Code Section 901(b)(1), U.S. citizens and U.S. corporations are entitled to a foreign tax credit for “the amount of any income, war profits, and excess profits taxes paid or accrued during the tax year to any foreign country or any possession of the United States. The taxpayer entitled to the credit is the taxpayer legally liable for the foreign tax under foreign law (the ‘technical taxpayer” rule). the technical taxpayer rule dates back to the Supreme Court’s 1938 decision in Biddle (See Biddle v. Commissioner of Internal Revenue Service No. 505 (1938)) and has since been implemented in income tax regulations. In Biddle, a shareholder in a United Kingdom (“U.K.”) company claimed a foreign tax credit for U.K. taxes imposed on corporate earnings distributed to the shareholder. Under the U.K. tax system, the U.K. company paid tax on its earnings and its distributions to shareholders were grossed up to reflect the corporate tax paid. The taxpayer claimed a foreign tax credit for the tax paid by the foreign corporation.

The statute at issue in this case provided a foreign tax credit for “income taxes paid or accrued to any foreign country.” The Supreme Court stated that the “decision must turn on the precise meaning of the words in the statute which grants to the citizen taxpayer a credit for foreign “income taxes paid.” According to the Court, “whether the stockholder pays the tax within the meaning of our statute must ultimately be determined by ascertaining from an examination of the manner in which the British tax is paid and collected what the stockholder has done in conformity to British law and whether it is the substantial equivalent of payment of the tax as those are used in our statute.”

The Court determined that the corporation, and not the shareholder, was legally required to pay the tax under U.K. law. The Court also observed that remedies for nonpayment ran against the corporation, not the shareholder, and that the shareholder could not be held liable for the tax in the event of the corporation’s failure to pay. The Court concluded that the shareholder could not be considered to have “paid” the tax, as that term was used in the U.S. tax law. Under the current income tax regulations for Internal Revenue Codes 901 and 903, “[t]he person by whom tax is considered paid for purposes of [Code Sections 901 and 903] is the person on whom foreign law imposes legal liability for such tax.

What Foreign Taxes Are Creditable?

Internal Revenue Code Section 901 limits the foreign tax credit to foreign taxes imposed on “income, war profits or excess profits.” Internal Revenue Code Section 903 extends the credit to foreign taxes imposed “in-lieu-of” an income tax. In order to be credible under Internal Revenue Code Section 901 or Internal Revenue Code section 903, a foreign levy must be a “tax.” A levy is a tax “if it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes.” Thus, as described below, the taxpayer’s payment of the tax must be compulsory and not voluntary.

The tax also must be levied by the country pursuant to its taxing authority, not some other authority- as a result, penalties, fines, interest, and customs duties are not considered taxes. In addition, a foreign levy is not a tax to the extent the person subject to the levy receives a “specific economic benefit” from the foreign country in exchange for a payment.

Only compulsory payments are considered payments of tax. a payment is not compulsory to the extent that the amount paid exceeds the amount of liability under foreign law for tax. The regulations provide that “[a]n amount paid does not exceed the amount of such liability if the amount paid is determined by the taxpayer in a manner that is consistent with a reasonable interpretation and application of the substantive and procedural provisions of foreign law (including applicable tax treaties) in such a way as to reduce, over time, the taxpayer’s reasonably expected liability under foreign law for tax.” An interpretation or application of foreign law is not considered reasonable if the taxpayer has actual notice or constructive notice, such as a published court decision, that the interpretation or application is likely to be erroneous. A taxpayer may generally rely on advice obtained in good faith from competent foreign tax advisors to whom the taxpayer has disclosed the relevant facts.

The taxpayer must also exhaust all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer’s liability for foreign tax (including liability to a foreign tax audit adjustment). A remedy is “effective and practical” only if the cost (including the risk of offsetting or additional tax liability) is reasonable in light of the amounts at issue and the likelihood of success. A settlement by a taxpayer of two or more issues will be evaluated on an overall basis in determining whether an amount is compulsory.

In a somewhat recent case, Procter & Gamble Co v. United States, 733 2d 857 (S.D. OHIO 2010) (“P&G”) a federal district court held that a taxpayer must initiate competent authority proceedings even where double taxation arises because of conflicting claims by two foreign countries, as opposed to between the United States and a foreign country. P&G claimed a credit for Japanese taxes paid in several tax years. In a later year, the Korean tax authorities determined that the income with respect to which the Japanese taxes had been paid was also subject to tax in Korea. The IRS disallowed P&G’s claim for a foreign tax credit for the Korean taxes. The court held that “[a]lthough P&G was required to pay Korean taxes, and was reasonably advised as to the legality and accuracy of the Korean claim by its Korean counsel, P&G failed to exhaust all effective and practical remedies including invocation of competent authority procedures available under applicable tax treaties….” to reduce the tax liability owed to Japan.”

Internal Revenue Code Sections 901 and 903 seem to indicate that “the predominant character of the foreign tax must be an income tax in the U.S. sense.” Two requirements must be satisfied to meet this test. The first requirement is that the foreign tax must be “likely to reach net gain in the normal circumstances in which it applies.” Three conditions must be satisfied for a foreign tax to meet this net gain prong. First, the tax must meet a “realization requirement.” In general, this requirement is met where the tax is imposed upon or subsequent to the occurrence if events that would result in the realization under the U.S. tax law. In certain cases, however, the realization requirement may be satisfied upon the occurrence of an event prior to realization or upon the occurrence of certain deemed distribution. Second, the foreign tax must be imposed on the basis of gross receipts (or gross receipts computed under a method that is likely to produce an amount that is not greater than fair market value). Third, the tax must satisfy a “net income requirement” – the base of the tax must be computed by reducing gross receipts to permit recovery of significant costs and expenses.

What Amount of Foreign Taxes Is Credible?

A foreign tax credit is allowed only to the extent that the credible tax is “paid or accrued.” An amount of tax is not considered paid to the extent that “it is reasonably certain that an amount will be refunded, credited rebated, abated, or forgiven.

Foreign Tax Credit Limitation and Baskets

A foreign tax credit generally is limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income (computed under U.S. tax accounting principles). The limitations is computed by multiplying the taxpayer’s total U.S. tax liability (prior to the foreign tax credit) in that year by the ratio of the taxpayer’s foreign source taxable income in that year to the taxpayer’s worldwide taxable income in that year. The limitation is applied separately to a “passive category income” basket and “general category income” basket. Passive category income includes income that would be foreign personal holding company income under Internal Revenue Code section 954(c) (e.g. dividends, rents, interest, and royalties).

In order to determine foreign source income for purposes of calculating a foreign tax credit, a taxpayer must allocate and apportion deductions between U.S. and foreign source income. The allocation and apportionment rules are complex but key to the determination of the foreign tax credit limitation. If expenses are over-allocated to foreign income, the taxpayer’s foreign tax credit limitation will be lower, resulting in less foreign taxes available to offset U.S. tax. If, on the other hand, expenses are under allocated to foreign income, the foreign tax credit limitation will be higher, resulting in more foreign taxes available to offset U.S. tax allocation and apportionment.

The tax attorneys at Diosdi Ching & Liu, LLP represent clients in a wide variety of domestic and international tax planning and tax controversy cases.

Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi represents clients in federal tax controversy matters and federal white-collar criminal defense throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.